Which should come first — paying off debt or saving? Many financial advisors recommend people in their twenties save 15% of their income, but simple math suggests getting rid of debt is better for your bank account.
The interest rate being earned on your savings is probably 1-2%, but the interest rate on your credit card debt could be over 20%. The choice seems obvious, but there are other issues that you should take into consideration. Here are three things to consider when evaluating where to focus your money.
Set aside funds for unexpected expenses
It’s not a question of whether you will have unexpected expenses, it’s a question of when and how much. If you have no money saved away, then you run the risk of falling further into debt when emergencies arise and expenses pop up. Without any savings, a $500 bill charged on a 17% interest credit card would cost you $659, and take 3 years and 7 months to repay making minimum monthly payments.
Setting aside a small emergency fund will reduce your risk of going deeper into debt. Putting aside just $2 a day for a year will leave you with more than $700 saved by this time next year.
Develop good savings habits early
While paying off debt is certainly a good money habit to have, it is easy to get caught in a debt cycle – continually either accruing or paying off debt. If you’re spending all of your financial focus on debt, it can be more difficult to develop good saving habits later.
Studies show that people who develop positive financial habits early on in their lives are more likely to make smart financial decisions as they grow older, so even while you are paying off debt consider getting in the habit of saving small amounts. Once you are debt-free, preserve your habit by continuing to make monthly payments into a savings or investment account.
Harness the power of compounding interest
If you wait too long to start saving, it can be very difficult to make up the difference later on because of the power of compounding interest.
In the charts below, Forbes illustrates the power of starting to save early by depicting four savings scenarios during a 40 year stretch. In each case, $1,000 is invested at the start of each month in a diversified portfolio.
The most dramatic difference is between Case 3 and Case 4, but the power of compounding is best illustrated by comparing Case 1 and Case 4. Both invested the same amount of money for 20 years, but because Case 1 started saving early the account continued to earn interest for 20 years and would be worth over $4.5M, while Case 4’s would be valued at $469K.
How do you balance the tug of war between your debt and saving goals? Tell us @upstart or on Facebook.